Remember this ...

So the price of crude oil is slipping now - dropping about $9 over the last two days, down to about $135 per barrel from a high of over $144 a barrel. Still hideously expensive, to be sure as oil cost only $87 per barrel in February this year. Yet this is definitely a very welcome trend for truckers that‘ve been staggered by $5 per gallon (or more) diesel fuel costs for some time now.

Or is it?

Here‘s my concern: We‘ve got VERY short memories here in the U.S. on the order of, say, a gnat. For the first time in decades, we‘ve managed to make a serious dent in our nation‘s petroleum use. For the first time ever, oil inventories did NOT decline over the Forth of July holiday weekend - in fact, consumers used 1.2% less gasoline than the week before and 3.9% less compared to the Fourth of July in 2007. Doesn‘t sound like a lot, but it‘s the first time gasoline demand has dropped so significantly.

Yet if pump prices start dropping, will we revert to our old ways? I am not talking about truckers here - freight‘s got to move - but about the general public, the folks that don‘t NEED to drive as much. The ones who can take public transportation to work, or carpool, or telecommute; the ones (like me) generating enough extra demand to push U.S. imports of the black stuff up near 60%, compared to 30% thirty years ago.

Then again, maybe things aren‘t what they seem. Maybe all the hype about speculators creating a “bubble” in the market, for example, aren‘t the real reason for the spike in oil prices we‘re experiencing. Some articles written by experts at the Cato Institute got me thinking about all this so let me share some of their analysis with you.

Alan Reynolds, a senior fellow with the Cato Institute and the author of “Income and Wealth,” says there is no mystery behind the rise in oil prices. “They rose too high too fast because of booming demand for oil for petrochemical products, electric power and shipping from many emerging economies, particularly China, India and the Middle East,” he explains. “Meanwhile, the supply of oil slipped in the U.S., Mexico, Venezuela, Nigeria and Russia.”

But now Reynolds says JPMorgan analysts estimate that oil will drop to $85 a barrel from 2009 to 2011. Even Goldman Sachs analyst Arjun Murti, who recently predicted oil might reach $200, later said oil will likely drop to $75 or less in the long run.

Why the change in outlook, you ask? Reynolds says the price of oil cannot reach $200. “In fact, that's quite impossible: The world economy can‘t handle current energy prices, much less a big increase,” he notes. “Which in turn means that oil prices will fall.”

In a column written for the New York Post, Reynolds points out that market analysts often claim oil prices are almost entirely determined by supply. Demand is said to be insensitive (or “inelastic”) to price. The standard example is that many Americans have to drive to work and most gas-guzzling SUVs will still be on the road even if the affluent few can trade theirs for a Prius. Whatever the price, we‘ll pay it.

Reynolds believes this idea rests on two fallacies. The first is to exaggerate the U.S.‘s importance when it comes to ups and downs in worldwide oil demand. In fact, America is using no more oil than it did in 2004. The second fallacy is to greatly exaggerate the importance of passenger cars in the U.S. - that‘s not where we should be looking for serious “demand destruction” in his words.

“Two-thirds of petroleum in the U.S. is used for transportation - but half of the transportation sector‘s fuel flows into commercial trucks, trains, buses, airplanes and ships,” he says. “As a result, only 44% of each barrel of oil is used to produce gasoline in this country, and some of that gasoline fuels business - delivery vans, landscaper trucks, fishing boats, industrial and farm machinery, etc.”

Most crude oil is used to produce diesel fuel for trucks, ships and trains, heavy fuel oil for industry, aviation fuel, asphalt, home heating oil, propane, wax, and innumerable petrochemical products ranging from detergents and drugs to synthetic fabrics and plastic, says Reynolds. In short, a huge share of crude oil is used to produce and distribute industrial products.

“That explains why the price of oil is extremely cyclical - that is, it tends to rise during economic booms and fall during contractions,” he notes. “It dropped 44% in the last recession (from November 2000 to November 2001), 48% from October 1990 to January 1992 - and 71% from July 1980 to July 1986.”

Note, too, the impact of a weak U.S. dollar, adds Steven Hanke, professor of applied economics at The Johns Hopkins University in Baltimore, MD, and like Reynolds a Cato senior fellow.

“For example, if the greenback had held its January 2001 value against the euro, oil would have traded at about $76 a barrel in May 2008,” he says. “This is almost $50 below the price that crude oil was trading at in May 2008. Accordingly, the decline of the dollar‘s value accounted for a whopping 51% of the $97 a barrel increase in the price of oil from May 2003-2008.”

Oil prices have a huge impact on producers‘ cost of production - profits and losses - not just on the cost of living for consumers, Reynolds noted. Nine out of 10 previous postwar recessions began shortly after a big spike in the price of oil. Yet those recessions always slashed oil prices dramatically, he stresses. “People who have been predicting both a nasty U.S, recession and $200 oil prices are contradicting themselves,” he says.

But note that a U.S. recession isn‘t required to bring down the price of oil. All that‘s needed is industrial stagnation or decline in many other countries. In the U.S. and Britain, industrial production is nearly flat - only 0.2% higher than it was a year ago. In many other countries, however, industrial production dropped over the past 12 months: down by 0.7% in Japan, 1.1% in Austria, 2.5% in Italy and Denmark, 2.9% in Canada, 5.4% in Greece, 5.7% in Singapore and 13.3% in Spain.

In April, industrial production also fell in India and China. Shrinking industry around the world shrinks demand for energy in general - and for oil in particular. “When the price of anything gets unbearably high, it discourages demand,” says Reynolds. “That has proven true of overpriced houses - and it will likewise prove true of overpriced oil.”

So demand is where it‘s at - and with demand for fuel falling in the U.S., oil prices should follow, as they seem to be doing now. Let‘s just hope we don‘t leave the path we‘re on in terms of lower consumption anytime soon.